A Small-Cap World After All

Are large-cap returns really due to pull ahead? Don't bet on it

For the past six years returns on small caps -- companies typically worth less than $3 billion -- have handily beaten those of large caps. And for much of that time, Wall Street strategists have been predicting that the situation would reverse itself. But the Russell 2000 index of small-cap stocks trounced the large-cap Standard & Poor's 500-stock index by 19 percentage points in 2003 and eight points in 2004, and eked out a third-of-a point win in 2005.

Surely 2006 will be the year that the big guys -- companies like DuPont (DD ) and Coca-Cola Co. (KO ) with market values of more than $10 billion -- will beat small fry such as Rambus (RMBS ) and Buffalo Wild Wings (BWLD ), right? The chorus has gotten even louder in recent months, with International Strategy & Investment Group Inc. (TSEIX ), an independent research outfit that caters to institutional investors, proclaiming on Feb. 27 that mega-cap U.S. stocks (companies worth more than $40 billion) are the cheapest asset class in the developed world.

So far, the small-cap skeptics have been wrong yet again. Through the end of February the Russell had a total return of 8.7%, while the S&P gained 2.9%. Projecting those two-month results over a year, small caps would outperform large caps by around 35 points in 2006.

But the doubters aren't giving in. Beyond the basic argument that what goes up must come down, big-cap boosters cite several factors that will bring the Chihuahuas to heel this year. Before the rally, small caps traded at a price-to-earnings ratio less than that of large caps, a historical anomaly that presented a huge opportunity as big-cap tech stocks crumbled. But today the Russell is once again pricier based on p-e.


What's more, say large-cap boosters, rising short-term interest rates will squeeze smaller companies that rely on short-term bank loans for financing. And with economic growth in the U.S. slowing and overseas economies heating up, big companies will derive significant portions of their revenue abroad, while small ones, as a group, won't. "All of the dynamics in the economy are favoring large caps," says David Reilly, director of portfolio strategy at Rydex Investments in Rockville, Md.

But don't be surprised if the experts are wrong again. The Federal Reserve has signaled that it's nearing the end of its rate hikes. And with the fed funds rate at 4.5%, short-term rates remain at historically low levels. Small companies are still able to borrow easily and cheaply. "The market looks out a year ahead," says Husam H. Nazer, manager of the TCW Small Cap Growth Fund, "and when it sees the Fed stopping, small-cap stocks will get a pop."

The assumption that large stocks should outperform in the next few years simply because they haven't in the past few may be flawed. Morgan Stanley (T ). "Small caps can outperform for a very long period."

Many of the factors behind small caps' run are still in place. These companies have reported stronger profit growth, a trend that may accelerate this year. In the fourth quarter of 2005, small-cap earnings rose about three points more than profits among large caps; that gap is projected to widen to eight points by the fourth quarter of this year. And much of the cash that's swelling the coffers of big companies -- and leveraged buyout firms -- is being used to acquire smaller companies. That should keep small caps percolating, say some analysts.


At the same time, the largest companies are finding it hard to keep growing. Many of the biggest stocks are "cheap for a reason," says UBS (UBS ) strategist Thomas Doerflinger. Giants such as Microsoft (MSFT ), Coca-Cola, and Dell (DELL ) have become so big that it's almost impossible for them to increase revenues at the rates of yore. Doerflinger points out, for instance, that Wal-Mart Stores Inc.'s (WMT ) annual sales increase is about half of British rival Tesco PLC's total sales. No wonder growth seekers are choosing the smaller company. Moreover, regulators and class action lawyers have increasingly taken on big banks, insurers, and other companies, diverting money and management time from growth opportunities. All of which explains why large caps can't get any lasting traction. The S&P actually beat the Russell by 0.55 point in February and outperformed it in 17 of the 36 months from 2003 to 2005. But its wins are smaller, and its losses, bigger.

And, anyway, what's wrong with the status quo? Morgan Stanley has found that since 1926, large caps returned an average of 7% a year when they were beating small caps, but 13% when they were trailing. Given that fact, does anyone really want a large-cap rally?

By Aaron Pressman

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